Independence

1. Independence Information from the Government Auditing Standards U.S. General Accounting Office

2. Dr. Carlos E. Johnson, ChairmanOklahoma Accountancy Board

3. General Standard “In all matters relating to the audit work, the audit organization and the individual auditor, whether government or public, should be free both in fact and appearance from personal, external and organizational impairments to independence.”

4. Entities affected by the standard: • Federal, state, local governments; • Colleges, universities, and trade schools; • Hospitals; • Charitable organizations; • School and utility districts; • Small businesses with SBA loans; • HUD projects, lenders and public housing authorities; • Not for profit and for profit recipients of federal grant and loan assistance.

5. Nongovernment auditors should also follow the AICPA code of professional conduct and the code of professional conduct of the state board with jurisdiction over the practice of the public accountant and audit organization.

6. 3 classes of Impairments: • Personal • External • Organizational

7. Personal impairment examples: • Family member who is a director, officer or employed in a position to exert direct and significant influence over the audited entity; • Financial interest that is direct or is significant/material though indirect, in the audited entity.

8. Personal Impairment examples: • Ideas toward individuals, groups, organizations or objectives of a particular program that could bias the audit; • Biases, political, ideological or social convictions that result from employment, loyalty or a particular type of policy. • Seeking employment with an audited organization during the audit.

9. To avoid personal impairmentsaudit organizations should: • Establish policy and procedure to identify personal impairments to independence; • Communicate policies and procedures to all auditors in the organization through training or other means and have auditors periodically acknowledging their understanding of independence requirements.

10. Auditors should avoid situations that could lead reasonable third parties to conclude that auditors are not able to maintain independence in conducting audits.

11. Two Overarching Principles • Audit organizations should not provide nonaudit services that involve performing management functions or making management decisions; • Audit organizations should not audit their own work or provide nonaudit services in situations where the nonaudit services are significant/material to the subject matter of audits (i.e., reconcile bank statements).

12. Overarching Principle 1: Auditors should not serve as members of an entity’s management committee or board of directors, make policy decisions that affect future direction and operation of an entity’s programs, supervise entity employees, develop programmatic policy, authorize an entity’s transactions or maintain custody of an entity’s assets.

13. Audit organizations should not audit their own work. Audit organizations should consider: Overarching Principle 2: Ongoing audits; Planned audits; Requirements for providing audits, including laws, rules, contractual agreements; Policies placing responsibilities on the audit organizations for providing audit services.

14. Nonaudit services documentation The audit organization should document its consideration of the nonaudit services. Documentation should include the rationale that providing nonaudit services does not violate the two overarching principles.

15. In cases where nonaudit services impair overarching principles: • The audit organization should communicate to management of the audited entity that the audit organization WILL NOT BE ABLE TO PERFORM SUBSEQUENT AUDIT WORK; • It should be clear to management that the audit organization would be in violation of the independence standard if it were to perform such audit work.

16. Nonaudit services impairment: • The audit organization cannot maintain or prepare the audited entity’s basic accounting records or take responsibility for basic financial records. Information must be approved by management.

17. Nonaudit services that would NOT generally create an impairment: • Providing basic accounting assistance such as preparing draft financial statements and notes; • Preparing a trial balance; • Provide limited payroll services; • Provide limited appraisal or valuation services; • Provide limited advisory services on IT; • Provide routine tax filings in accordance with IRS, state and local authorities;

18. If the audit organization prepares DRAFT financial statements and notes and performs the financial statement audit, management should acknowledge the audit organization’s role in preparing the financial statements and notes and management’s review, approval and responsibility for the financial statements and notes in the management representation letter.

19. Likewise, if the audit organization converts cash-based financial statements to accrual-based financial statements, management should acknowledge the audit organization’s role in reflecting accruals and management’s review, approval, and responsibility for the accrual adjustments in the management representation letter.

20. Management representation letter • A management representation letter is required by generally accepted auditing standards (GAAS) and GAGAS.

21. External Impairments: • External impairments occur when auditors deter from acting objectively and exercising professional skepticism by pressures from management and employees of the audited entity.

22. External impairment examples: • External interference that could limit the scope of an audit; • Unreasonable restrictions of the time allowed to complete an audit or issue a report; • Influences that jeopardize the auditors’ continued employment for reasons other than incompetence, misconduct or the need for audit services.

23. Organizational Impairments: • A government audit organization’s ability to perform work and report the results impartially can be affected by its place within government and the structure of the government entity that the audit organization is assigned.

24. Audit organizations may be free from organizational impairment if: • A federal auditor auditing a state government program; • If assigned to a different branch of government within the same level of government as the audited entity; • Audit organization’s head directly elected by voters of the jurisdiction being audited; • If statutory protections prevent the abolishment of the audit organization by the audited entity.

25. Questions about Applying the Independence Standard in Specific Nonaudit Circumstances: Taken from Government Auditing Standards Dated July 2002 GAO-02-870G

26. Bookkeeping Services • Several questions have been raised regarding an audit organization’s development of draft financial statements and notes and other bookkeeping services. Before responding to those questions, in the next Government Auditing Standards update, we plan to add the following requirement as a footnote after the first sentence in paragraph 3.26a.

27. Bookkeeping Services • If an audit organization has prepared draft financial statements and notes and performed the financial statement audit, it should obtain from the audited entity’s management an acknowledgement in its management representation letter, required by Government Auditing Standards, the audit organization’s role in this regard and entity management’s review, approval, and responsibility for the financial statements and related notes. Likewise, if the audit organization converts cash-based financial statements to accrual-based financial statements, it should obtain from the audited entity’s management an acknowledgement in its management representation letter the audit organization’s role in reflecting accruals and entity management’s review, approval, and responsibility for the accrual adjustments.

28. Question 46 • 46. Can an audit organization be involved in preparing a trial balance and draft financial statements and notes without impairing its independence to audit the financial statements? Can audit engagement team members perform these activities?

29. Question 46 Answer • Maintaining the audited entity’s books and records is the responsibility of its management. Accordingly, management is responsible for ensuring that these books and records adequately support the preparation of financial statements in accordance with generally accepted accounting principles and that records are current and in balance.

30. Question 46 Answer (cont.) • If an audit organization were asked to prepare a trial balance, the audit organization would not impair its audit independence if the preparation of the trial balance was purely technical in nature. The trial balance should be based on management’s chart of accounts, and the audited entity’s management must take responsibility for the trial balance. In other words, the preparation of the trial balance is a matter of formatting the chart of accounts into a trial balance. Work involving more than the technical formatting of the trial balance would impair independence because the audit organization would be performing a management function, which would violate an overarching principle.

31. Question 46 Answer (cont.) • The audit organization’s preparation of draft financial statements and note disclosures from a trial balance provided by entity management (or prepared by the audit organization as described above), which the management of the audited entity then reviews and approves, would not impair the auditor’s independence (see paragraphs 3.26 and 3.26a). This work is considered technical assistance and as part of the audit. The audit organization must be careful not to make management decisions, and management of the audited entity must have the knowledge to evaluate and approve the draft financial statements and notes and take responsibility for them.

32. Question 46 Answer (cont.) • Further, the audit engagement team that prepared the trial balance and draft financial statements and notes could also perform the financial statement audit. The audit organization must comply with all other safeguards in paragraph 3.25. Also, the management representation letter, required by auditing standards, should acknowledge the audit organization’s role in preparing the trial balance and draft financial statements and related notes, and management’s review, approval, and responsibility for the financial statements and related notes.

33. Question 46 Answer (cont.) • Likewise, auditors can convert cash-based financial statements to accrual-based financial statements, as long as management is in the position to make informed judgments to review, approve, and take responsibility for the appropriateness of the conversion. In providing this service, the audit team that proposed the accruals could also perform the financial statement audit since this service is in substance the same as proposing adjusting or correcting entries as long as management makes the decision on accepting the entries. Similarly, as stated above, the management representation letter should also acknowledge the audit organization’s role in reflecting accruals and management’s review, approval, and responsibility for the accrual adjustments.

34. Question 46 Answer (cont.) • It is important to reiterate that the answer to this question is conditioned on the audit organization starting with appropriate books and records that balance and the audited entity having knowledgeable management. Where this is not the case, the audit organization must be careful not to cross the line of making management’s decisions or performing management functions and find itself in a position where reasonable third parties with knowledge of the relevant facts and circumstances could conclude that the auditor has, in effect, maintained the audited entity’s books or records and, therefore, has impaired its independence to conduct the financial statement audit.

35. Question 47 • 47. The AICPA defines the compilation of financial statements as presenting in the form of financial statements information that is the representation of management without undertaking to express any assurance on the statements. This definition acknowledges that the audit organization might find it necessary to perform other accounting services to compile the financial statements, such as adjusting the books of accounts or consulting on accounting matters. Can an audit organization provide a compilation service without impairing independence to audit subsequent period financial statements?

36. Question 47 Answer • Yes. Compilations are generally performed to periodically supply financial information in an understandable format, such as quarterly financial statements. Similar in substance to drafting financial statements and notes, the compilation of financial information would not impair the audit organization’s independence as long as it does not make management decisions and management of the audited entity has the knowledge to evaluate and approve the compilation and to take responsibility for it. Also, the team that performed the compilation could perform the financial statement audit as long as the audit organization complies with the other safeguards in paragraph 3.25.

37. Question 47 Answer (cont.) • Similar to our answer to the previous question regarding the preparation of draft financial statements and notes, we reiterate that our answer is conditioned on the audit organization starting with appropriate books and records and the audited entity having knowledgeable management. Therefore, the audit organization was able to perform the compilation without having to reconstruct the books and records, and the audited entity’s management was in a position to take responsibility for the compilation.

38. Question 48 • 48. Paragraph 3.26a of the independence standard states that independence is impaired if the audit organization maintains or prepares an audited entity’s basic accounting records or maintains or takes responsibility for basic financial or other records that an audit organization will audit. What is considered to be an entity’s basic accounting records and basic financial or other records?

39. Question 48 Answer • Basic accounting and financial records are considered to be source documents or originating data evidencing transactions have occurred (for example, purchase orders, payroll time records, and customer orders). Such records would also include an audited entity’s general ledger and subsidiary records, or equivalent. Supporting schedules are not considered to be basic accounting or financial records, as long as management has made all the decisions in key areas regarding these supporting schedules. An example of a supporting schedule is a depreciation schedule, which the next question discusses further.

40. Question 49 • 49. Can an audit organization assist an audited entity’s management in preparing depreciation schedules without impairing its independence to perform the financial statement audit?

41. Question 49 Answer • Yes, as long as the audited entity’s management has determined such key factors as the method and rate of depreciation and the salvage value of the assets. If the audit organization makes these decisions, it has violated an overarching principle. To not impair its independence, the audit organization’s service must be limited to calculating the depreciation, and the audited entity’s management must take responsibility for the depreciation schedules.

42. Question 49 Answer (cont.) • The audit organization must take care that the extent of its work does not cross the line and place it in a position where reasonable third parties with knowledge of the relevant facts and circumstances could conclude that the auditor’s independence is impaired. Also, given the nature of this nonaudit service, the audit organization would not have to apply the safeguard precluding personnel who provided the nonaudit services from auditing their own work. However, the remaining safeguards in paragraph 3.25 would apply.

43. Question 50 • 50. If the audit organization posts transactions coded by the audited entity’s management, would the audit organization’s independence be impaired to perform the financial statement audit?

44. Question 50 Answer • Yes. Paragraph 3.26a specifically addresses the posting of transactions, whether coded by management or not, to an entity’s financial records or to other records that subsequently provide data to an entity’s financial records. An audit organization cannot provide this service without impairing its independence to perform the financial statement audit.

45. Question 51 • 51. An audit organization arrives at an audited entity for the first day of fieldwork and finds that the last quarter’s cash receipts and disbursements and other transactions have not been recorded. To assist the audited entity in updating its financial records, the audit organization agrees to prepare and post all transactions to the general ledger based on the audit organization’s professional judgment. Would the audit organization’s independence be impaired to perform the financial statement audit?

46. Question 51 Answer • Yes. The audit organization would be posting transactions to the audited entity’s general ledger, which impairs its independence as discussed in paragraph 3.26a.

47. Question 52 • 52. An audited entity provides an audit organization with a record of all cash receipts and cash disbursements made during the period. The audit organization (1) determines the appropriate classification of each transaction based on the available information (such as payee and description), (2) posts current-year transactions to the prior-year adjusted balance sheet and then determines necessary adjustments to convert the financial information to the accrual basis of accounting, and (3) uses this adjusted information to draft financial statements, which are reviewed with and approved by an audited entity. In this case, would an audit organization’s independence be considered impaired to perform the financial statement audit?

48. Question 52 Answer • Yes. Determining the appropriate classification of receipts and disbursements, in substance, would be the same as maintaining/preparing an audited entity’s basic accounting records. Likewise, posting current year transactions to the prior year’s balance sheet has the same affect as posting transactions to the audited entity’s financial records. As discussed in paragraph 3.26a, activities such as these would impair an audit organization’s independence to perform the financial statement audit.

49. Question 53 • 53. An audited entity provides its cash receipts and disbursements journals to the audit organization, which, as part of its financial statement audit, proposes adjusting entries to convert from a cash basis to an accrual basis of accounting. The audited entity’s management, which has requested the conversion, reviews, approves, and posts the entries and has sufficient knowledge and ability to take responsibility for them. Would the audit organization’s independence be considered impaired for the financial statement audit?

50. Question 53 Answer • No. An audit organization could perform these activities as part of a financial statement audit without impairing its independence, provided management of the audited entity is in a position to evaluate and take responsibility for results of the conversion. As with the answers to the earlier question related to converting financial statements from a cash to an accrual basis, this answer assumes that the cash receipts and disbursements journals only have to be converted and do not have to be reconstructed to such an extent that the audit organization, in substance, would be maintaining or preparing the audit entity’s basic accounting records.